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Credit Risk ManagementEnhancing Your Bottom LineEbrahimEbrahim Shabudin ShabudinManaging Director Managing Director Deloitte&Touche LLPDeloitte&Touche LLPThe AFP 23rd Annual Conference New OrleansNovember 3-6,2002Credit BackgroundThorough identification and accurate Thorough identification and accurate measurement of credit risk,supported by strong measurement of credit risk,supported by strong risk management can help improve the bottom risk management can help improve the bottom lineline.An uncertain and volatile economic.An uncertain and volatile economic environment significantly impacts this abilityenvironment significantly impacts this ability.The desire to grow and turn in outstanding.The desire to grow and turn in outstanding results has a tendency to put pressure on the results has a tendency to put pressure on the checks and balances within businesseschecks and balances within businessesValue PropositionCredit plays a critical role in“selling”products and servicesCredit plays a critical role in“selling”products and services Expands revenue opportunities with creditworthy,incremental Expands revenue opportunities with creditworthy,incremental customerscustomers Utilizes innovative structures to support business relationshipsUtilizes innovative structures to support business relationshipsEffective credit risk management limits credit losses and provides Effective credit risk management limits credit losses and provides stable cash flows and earningsstable cash flows and earnings Marketplace rewards companies exhibiting earnings and cash flow Marketplace rewards companies exhibiting earnings and cash flow stability with higher P/E multiplesstability with higher P/E multiples Marketplace penalizes credit induced volatility and“surprises”Marketplace penalizes credit induced volatility and“surprises”Raises questions about quality of managementRaises questions about quality of managementCorporate Credit RiskCompanies are exposed to significant levels Companies are exposed to significant levels of credit risk emanating from different sourcesof credit risk emanating from different sourcesAccounts Receivables Accounts Receivables Other Notes ReceivablesOther Notes ReceivablesBuyer and Franchise FinancingBuyer and Franchise FinancingWith Recourse FinancingWith Recourse Financing Project FinanceProject Finance Structured TransactionsStructured Transactions Leases with RecourseLeases with RecourseDerivatives Exposures Derivatives Exposures FX,Interest Rate Risk,Commodities etc.FX,Interest Rate Risk,Commodities etc.Collateral RiskCollateral Risk Parent or Third Party Guarantees Parent or Third Party Guarantees Commercial and Standby Letters of CreditCommercial and Standby Letters of Credit Note also that Critical Suppliers to the company Note also that Critical Suppliers to the company may pose specific credit riskmay pose specific credit riskDSO Impact an exampleActualActualCompany ACompany APeer AveragePeer AverageQ3 A/RQ3 A/R$295,396,000$295,396,000Q3 SalesQ3 Sales$261,201,000$261,201,000 DSOs=DSOs=124*124*51.351.3HypotheticalHypotheticalD D CashCashDSOsDSOs51.351.3Q3 SalesQ3 Sales$261,201,000$261,201,000 Q3 A/R=Q3 A/R=$122,002,230$122,002,230+$173,393,770+$173,393,770*Equals 295.4M/261.2M x 90(or number of days in sales period)Equals 295.4M/261.2M x 90(or number of days in sales period)Credit as a FacilitatorCredit risk management is important Credit is a facilitator of business growth and Credit is a facilitator of business growth and performanceperformance High business margins tend to attract lower quality High business margins tend to attract lower quality clients and therefore higher risk profile to manageclients and therefore higher risk profile to manage Clients(buyers)may be concentrated in selected Clients(buyers)may be concentrated in selected industries and provide limited portfolio diversification industries and provide limited portfolio diversification opportunityopportunity Poor credit risk management resulting in negative Poor credit risk management resulting in negative impact to bottom-line is heavily penalized by marketsimpact to bottom-line is heavily penalized by marketsCredit Strategy&Risk ToleranceuSpecific Quantifiable ObjectivesuManagement Review MethodologyuCredit Strategy Statement and Risk ToleranceuCoordination with Business PlanThe business strategies and objectives drive the establishment of creditpolicies and procedures.Measurement and reporting as well as the use of current technologies enhance credit decision-making and improve risk management.The entire process is continually re-evaluated and improved.Credit Risk Areas to ConsiderCredit PolicyCredit PolicyCredit Approval Credit Approval AuthorityAuthorityLimit SettingLimit SettingPricing Terms Pricing Terms and Conditionsand ConditionsDocumentation:Documentation:Contracts and Contracts and CovenantsCovenantsCollateral and Collateral and SecuritySecurityCollections,Collections,Delinquencies Delinquencies and Workoutsand WorkoutsExposure Exposure ManagementManagement AggregationAggregation ControlControlPeriodic Account Periodic Account ReviewsReviews Payments/AgingPayments/Aging Credit ConditionCredit ConditionCompliance with Compliance with Covenants,TermsCovenants,TermsTechnology/ReportsTechnology/Reports Transactions/Transactions/BookingsBookings Risk-adjusted Risk-adjusted ReturnReturnn nSales Sales ChannelsChannelsn nRisk StrategyRisk Strategyn nUnderwriting Underwriting StandardsStandardsn nCredit Credit ApplicationApplicationn nAnalysisAnalysisuuBusiness/Business/IndustryIndustryuuFinancialFinancialuuCreditCreditn nCredit Scoring Credit Scoring and Ratingsand RatingsOrigination/AssessmentAdministrationMonitoring/ControlRiskManagementn nPortfolio Portfolio ManagementManagementn nConcentrationConcentrationn nDiversificationDiversificationn nAllowance for Allowance for Bad DebtsBad Debtsn nRisk Risk MitigationMitigationn nObjectivesObjectivesn nType of Type of ExposureExposuren nInstruments or Instruments or MethodsMethodsValue CreationBusiness Performance MeasuresPerformance-based management utilizes metrics that measure actual performance against predetermined thresholds.The thresholds are established taking into account the organizations strategy,operatingenvironment and process controls.The measures drive value creation and should support problem identification and correction.nBusiness StrategySystemsOperationsFinancePerformance ManagementCredit AnalysisCredit DecisionsCollectionsCREDIT POLICYRISK MANAGEMENTCredit Risk Managements Inter-related ActivitiesComplianceOriginationReportingCredit Policies&Procedures Analysis&RiskManagementGovernance,Controland ImplementationMeasurementMethodologiesTechnology&Data IntegrityCredit Strategy&Risk ToleranceA complete and coherent risk management A complete and coherent risk management framework contains the following elementsframework contains the following elementsCredit Risk ManagementCredit Risk ManagementA New ParadigmA new business paradigm had evolved:causing A new business paradigm had evolved:causing a lack of reliance on good fundamental analysisa lack of reliance on good fundamental analysisThe idea that stock market values would The idea that stock market values would continue to go up indefinitelycontinue to go up indefinitelyIncreasingly competitive,complex and volatile Increasingly competitive,complex and volatile market placemarket placeHigher than expected actual debt burdensHigher than expected actual debt burdensExtensive reliance on unrealistic future cash Extensive reliance on unrealistic future cash flowsflowsFailures in corporate governanceFailures in corporate governanceQuestionable personal and corporate ethicsQuestionable personal and corporate ethicsImplications for Corporate GovernanceCurrent organization structures to be revisitedCurrent organization structures to be revisitedClarity around roles and responsibilitiesClarity around roles and responsibilitiesNeed for honesty,integrity and independence Need for honesty,integrity and independence(self-regulation)(self-regulation)Technical expertise of people and strong Technical expertise of people and strong management processesmanagement processesImproved disclosure requirementsImproved disclosure requirementsImportance and implementation of sanctionsImportance and implementation of sanctionsIncreased legislation and compliance Increased legislation and compliance requirementsrequirements Vision:Vision:Managing Risk/ReturnManaging Risk/ReturnPricing decisions,Performance measurement,business and customer segmentation,compensation,etc.A business model view of Credit Risk Infrastructure componentsCredit Risk Management Strategic VisionDevelopment Stages Foundation StageFoundation Stage includes application of risk identification includes application of risk identification methodologies,risk scoring or rating systems and strong methodologies,risk scoring or rating systems and strong underwriting standardsunderwriting standards Basic StageBasic Stage tends to include managing on a transactional basis by tends to include managing on a transactional basis by evaluating specific attributes such as structuring,collateral and evaluating specific attributes such as structuring,collateral and pricingpricing Advanced StageAdvanced Stage represents managing on a portfolio basis represents managing on a portfolio basis including aspects such as concentrations,correlations and including aspects such as concentrations,correlations and diversificationdiversification The Sophisticated StageThe Sophisticated Stage includes application of highly developed includes application of highly developed measurement techniques for transactions and portfolios,supported measurement techniques for transactions and portfolios,supported by decision-making relating to segments or businesses against by decision-making relating to segments or businesses against established hurdle rates.established hurdle rates.Credit Risk ClarifiedCredit risk is defined as the risk of loss or potential Credit risk is defined as the risk of loss or potential loss resulting from:loss resulting from:Default in contractual obligations by a customerDefault in contractual obligations by a customer Migration in condition and ratingMigration in condition and rating Deterioration in performance Deterioration in performance Credit risk includes both an expected(predictable)Credit risk includes both an expected(predictable)and unexpected(volatile)loss component.and unexpected(volatile)loss component.Businesses have to contend with Expected and Unexpected LossesExpected LossesExpected Losses AnticipatedAnticipated Cost of doing businessCost of doing business Charged to provisionsCharged to provisions Captured in pricingCaptured in pricing Relatively easier to Relatively easier to measuremeasureAssessing expected loss Assessing expected loss includes determining includes determining exposure,default probability exposure,default probability and severityand severityUnexpected LossesUnexpected Losses Unanticipated but Unanticipated but inevitableinevitable Must be planned forMust be planned for Covered by reservesCovered by reserves Allocated to businessesAllocated to businesses Difficult to measureDifficult to measureAssessing unexpected loss Assessing unexpected loss requires making qualitative requires making qualitative judgments around potential judgments around potential volatility of average lossesvolatility of average lossesCredit Risk Management ExplainedAlthough credit risk may be difficult to measure it is Although credit risk may be difficult to measure it is important to estimate and manageimportant to estimate and manage What does Credit Risk Management mean?What does Credit Risk Management mean?It represents an institutions ability to properly identify It represents an institutions ability to properly identify and evaluate the potential risk of default in payment of and evaluate the potential risk of default in payment of obligations of customersobligations of customers It incorporates the firms ability to effectively manage It incorporates the firms ability to effectively manage and control this exposure in a way that is consistent and control this exposure in a way that is consistent with the institutions business strategy,risk appetite with the institutions business strategy,risk appetite and credit cultureand credit cultureImportant Building BlocksEffective Credit Risk Management requiresEffective Credit Risk Management requires Clear origination and underwriting standards Clear origination and underwriting standards A strong corporate and credit cultureA strong corporate and credit culture Highly developed risk measurement techniques Highly developed risk measurement techniques Ability to recognize and cover expected and unexpected Ability to recognize and cover expected and unexpected losseslosses Pricing commensurate with risks undertakenPricing commensurate with risks undertaken Methodologies to assess net profit contributions by Methodologies to assess net profit contributions by customers and appropriate business segmentscustomers and appropriate business segments Proper allocation of capital and management resourcesProper allocation of capital and management resourcesIn order to:In order to:Improve overall corporate performance,measured by a Improve overall corporate performance,measured by a higher EPS or P/E ratio(or market value)higher EPS or P/E ratio(or market value)Credit Policy and ProcessCredit Policy should be clear and conciseCredit Underwriting Standards must be developed and included in policyCredit Processes should be reasonable and allow quick response to clientsHealthy balance between sales and credit approval should exist and be respectedRisk MonitoringExposure must be complete and currentRegular reporting and updating of clients payment performance Minimum annual reviews of clients should be performedFinancial conditions should be regularly assessedRequired action must be initiated and follow up must take placeContract Terms and DocumentationContract negotiations must take place at the Contract negotiations must take place at the right level in the organizationright level in the organizationAppropriate approvals must be obtainedAppropriate approvals must be obtainedInternal or external legal departments must Internal or external legal departments must document completelydocument completelyTerms and conditions should be understood and Terms and conditions should be understood and compliance mechanism put in placecompliance mechanism put in placeExceptions must be reported and managed Exceptions must be reported and managed urgently to resolutionurgently to resolutionRisk Rating System EffectivenessCredit Scoring is generally used to“risk rate”homogeneous portfoliosCredit Scoring is generally used to“risk rate”homogeneous portfolios Highest applicability is in consumer and retail portfoliosHighest applicability is in consumer and retail portfolios Some advanced scoring systems are being migrated for use in rating Some advanced scoring systems are being migrated for use in rating“middle market”clients“middle market”clients Such models are only as good as the underlying assumptionsSuch models are only as good as the underlying assumptionsInternal credit rating systems are difficult to assess and are often not Internal credit rating systems are difficult to assess and are often not independently validatedindependently validated Client relationship may interfere with objective assessment of risksClient relationship may interfere with objective assessment of risks Rating criteria usually a matter of practice rather than written policyRating criteria usually a matter of practice rather than written policy Ratings are not consistent over timeRatings are not consistent over time Qualitative credit assessments often lag current market informationQualitative credit assessments often lag current market information Institutions often assumeInstitutions often assume a mapping with external ratings in order to a mapping with external ratings in order to quantify credit riskquantify credit riskEffective Risk Rating Systems Sufficient granularity of risk rating categoriesSufficient granularity of risk rating categories Accurate and timely assignment of ratings Accurate and timely assignment of ratings Clear and consistent application of default definitionClear and consistent application of default definition Periodic calibration,triangulation and validation of risk Periodic calibration,triangulation and validation of risk ratings ratings Accurate identification of migration of transactions and Accurate identification of migration of transactions and portfolios(as reflected by upgrades and downgrades in portfolios(as reflected by upgrades and downgrades in ratings)ratings)Credit Evaluation:Financial FactorsGet the information you need to make a full analysisSome information will need to be cross-checked and obtained on a regular and timely basisBe constructively cynical:new business models are difficult to pull offBe cognizant of delaying tacticsNumbers dont tell the whole story!Credit Evaluation:Qualitative FactorsEvaluation of subjective factors is often times Evaluation of subjective factors is often times more important than the numerical analysismore important than the numerical analysisPeople make a business:visions,values and People make a business:visions,values and strategies are only words unless people strategies are only words unless people implement themimplement themManagement,industry,product,geography,Management,industry,product,geography,competition etc.all influence results and must be competition etc.all influence results and must be properly assessedproperly assessedAnalysis-paralysis may lead to wrong decisionsAnalysis-paralysis may lead to wrong decisionsArt and Science of JudgmentGetting access to the best clients and all the relevant information is a challengeEnsuring proper analysis is done requires a strong corporate cultureUtilizing qualified resources both internally and externally enhances the resultsOften the lack of the will to act is what causes high lossesConcluding CommentsCompanies that measure and manage credit Companies that measure and manage credit risk in a pro-active manner will benefit from a risk in a pro-active manner will benefit from a favorable risk profile resulting in favorable risk profile resulting in Higher revenueHigher revenue Lower lossesLower losses Improved efficienciesImproved efficiencies Higher EPS,P/E ratios and market valuesHigher EPS,P/E ratios and market valuesConcluding CommentsRisk Assessment and Limit ManagementCredit Infrastructure and Portfolio ManagementCredit Analytics SupportCredit Technology EnablementCredit QualityCredit UnderwritingRisk Rating System EffectivenessCounterparty and Portfolio LimitsOrganizational Structure Policies and ProceduresTechnology Selection and ImplementationProblem Asset ManagementRisk Rating CalibrationTransaction Pricing,Structure and SupportDefault Probability and Recovery CalibrationCredit Reserve MethodologyRisk Based Pricing ModelsRisk Adjusted Return AnalysisPortfolio Value MeasurementCredit Risk MeasurementCredit Performance Scorecards Internal Software Internal Software External Vendor SoftwareExternal Vendor SoftwareAppendix:Business Proposal ChecklistBusiness Proposal SummaryBusiness Proposal Summary Customer,Rating,Legal Status,Line of BusinessCustomer,Rating,Legal Status,Line of Business Guarantor,if anysameGuarantor,if anysame Collateral,if anytrue value explainedCollateral,if anytrue value explained Other Support,if any.Legal or moral onlyOther Support,if any.Legal or moral only The Transactionrisks and mitigationThe Transactionrisks and mitigation Amount,purpose,terms and conditionsAmount,purpose,terms and conditions Sources of repayment clearly identifiedSources of repayment clearly identified Client payment history and relationshipClient
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